Saxo Q2 Outlook: The Fragmentation Game and the world rebalancing away from western dominance

Saxo, the online trading and investment specialist, has today published its Q2 2023 Quarterly Outlook for global markets, including trading ideas covering equities, FX, currencies, commodities and bonds, as well as a range of central macro themes impacting client portfolios.

Recent turmoil in the banking sector has sent shockwaves through global financial markets. In turn, Saxo’s Q2 Outlook looks to address the impact of this crisis, which will have important short, medium and long term consequences for both the banking system and the global economy.

“Silicon Valley Bank became the poster child for a very old kind of panic, one in which depositors lost faith in the bank and made for the exit all at once,” explains Saxo’s Chief Investment Officer, Steen Jakobsen. Unlike the Global Financial Crisis, “this banking crisis is not about the solvency of banks, but whether the banks can continue to operate profitably if funding costs rise.”

Jakobsen also addresses the fragmentation of supply chains as nations across the world ensure that critical resources are available within their borders or through a friendly trading partner. The world’s trade, while still global, has fragmented into new blocs and alliances as the world rebalances away from western dominance – this is the Fragmentation Game.

Combined with the ongoing impact of the war in Ukraine, the highest bond volatility in history and monetary authorities’ inflation policy decisions, these events will require investors to reconsider how the world is ordered and what this new configuration will mean for their investments for the coming quarters, years and decades.

Equities and a world of unknowns

“This year so far has truly been a rollercoaster for investors,” says Peter Garnry, Head of Equity Strategy at Saxo. A strong equity market in the first two months of the year was supported by “financial conditions still not tight enough to curb inflation, and mild weather in Europe averting an energy crisis.”

This has “pushed our MSCI World valuation model considerably above the historical average, lowering the future expected real rate return,” he added. “We live in a world of lower expected returns until asset classes have adjusted to lower valuations amid the acceptance of structurally higher inflation.”

As for the Fragmentation Game, “it is essentially a strategic geopolitical dynamic of ensuring more robust access to energy, technology and defence among large competing nation states.” What’s more, “fragmentation of the global economy will likely put inflation at a higher structural level, and the cost of capital will likely go up, squeezing low quality and leveraged companies.”

Developed market weakness versus emerging market strength

“Key commodities from crude oil to copper and iron ore started 2023 with strong gains in the belief that a post-pandemic recovery in China, the world's top consumer of raw materials, would more than offset darkening economic clouds in Europe and the US,” notes Ole Hansen, Head of Commodity Strategy at Saxo.

However, China’s reopening was not strong enough “to offset the negative impact of rising rates,” particularly following the Fed’s positioning and what markets could see as “recession by design, i.e., the Fed prepared to take aggressive action in order to cool inflation, no matter the economic impact, meaning higher rates and for much longer than previously anticipated.”

The impact of the Fragmentation Game is also being felt across commodity markets – namely in the energy sector. Copper in particular is being supported by “rising demand from electrical vehicles, renewable power generation and energy storage and transmission.”

What happens when a tightening cycle ends before inflation is defeated?

“With perfect hindsight, the tightening cycle that kicked off in late 2021, but really didn’t accelerate until the summer of last year, was too much and too fast for the weakest links in the global financial system,” explains Saxo’s Head of FX Strategy John Hardy.

The interest rate cycle has now turned sharply – it is time to consider the next slowdown. “If bond markets ring the alarm bell, central banks must swing into action and will ultimately implement Bank of Japan-style yield curve control (YCC). The move may not be explicit at first, but it will be de facto. And it means we are now crossing the threshold into this new era in which central banks have lost their independence.”

“Currency investors will have to determine which currencies are likely to offer the least bad negative real rates and which assets can maintain the highest real returns (hard assets and companies that can raise prices at inflation or better) and which economies offer the most of these assets in a world engaging in the Fragmentation Game.”

A whole new world of higher interest rates

“Policymakers have moved quickly to get a handle on recent market stress,” says Christopher Dembik, Head of Macro Analysis at Saxo, providing access to emergency lending and USD swap lines to boost dollar liquidity. “But this liquidity backstop – which is in no way comparable to Quantitative Easing – won’t go to the real economy. That’s what should worry us.”

“The level of uncertainty is unusually high. Market participants need to focus on the impact of the unfolding market stress on broad lending conditions and the deeper structural weaknesses among smaller banks, especially with respect to commercial property.” This is a concern not only in the US, but in Europe and the UK, as “higher interest rates and lower affordability in the real estate sector are also destabilising the financial and macro landscape.”

China and the global fragmentation game

Since its economic reforms and opening up in the 1980s, China has increasingly integrated with the world economy. Saxo’s Hong Kong-based strategist, Redmond Wong, explains that the country’s “decades long, labour- and energy-intensive, export-oriented model has benefited from globalisation,” and how it “seeks to play a bigger role in multilateral economic institutions of the prevailing international economic order established by the United States after the Second World War.”

Specifically, as competition with the US intensifies, “China is looking to displace the American order, not entirely, but selectively and regionally.” It is achieving this objective by embracing globalisation while also curating specific alliances and regional bloc-building across central Asia and the Middle East to position itself favourably within the global order. However, China still faces a number of challenges as it seeks to secure vital resources – including technology and data.

India and Southeast Asia offer calm in the storm

Despite the economic, political and financial restructuring of the world, Saxo Macro Strategist Charu Chanana says that “India remains a partner of choice for many global economies, not just in terms of trade, but also in security and technology, and bringing long-term investment opportunities in a fragmenting world.”

Looking to overcome the nation’s traditional speed-limiters including protectionism and burdensome bureaucracy, “India is working hard to position itself as an attractive manufacturing and export hub for multinational companies,” as well as “reducing trade barriers, eliminating tariffs and looking to gain preferential access to global markets,” and focusing on bilateral trade agreements.

Meanwhile, as markets remain nervous, “it is also prudent to emphasise the benefits of diversification.” Asian credit “especially at the front end of the curve, remains far less vulnerable in light of a somewhat lower degree of policy tightening in the region in the current cycle.” It also “continues to be supported by a better growth outlook in China, in contrast to the rising recession as well as financial risks in the US.”

Protecting a long stock market position from turbulence

Following the recent turmoil in global financial markets, investors will be looking at ways to protect their portfolio. “One way to reduce risk while maintaining upside potential – markets sometimes recover faster than expected – is to use an options collar,” explains Investment Coach Hans Oudshoorn.

While the strategy is typically applied to individual stocks, “it can also be done relatively easily at a portfolio level if the portfolio is in close correlation with the broader market.”

Implementing such an approach allows investors to build in a certain amount of protection to their portfolio, however, “it is not a construction for pursuing high returns.” Rather, “it is a safety belt for the underlying portfolio while maintaining some upside potential if the underlying instrument rises.”

To access Saxo’s full Q2 2023 Outlook, with more in-depth pieces from its analysts and strategists, please go to: https://www.home.saxo/en-ch/insights/news-and-research/thought-leadership/quarterly-outlook